Our Ref. LRRM/KL/L/006/2003

The Honourable Antony Leung Kam-chung, GBS JP
Financial Secretary
Government of the Hong Kong
Special Administrative Region
of the People's Republic of China
Central Government Offices
12/F West Wing, Lower Albert Road
Central
Hong Kong

Dear Sir

The Board of HKEx has seen the Report ("Report") of the Expert Group ("Group"). Although we have had little time to consider it in detail, the Board (which met on 28 March) has asked me to express its deep and unanimous concern that implementation of the recommendations of the Group, without more thorough consideration, would risk doing serious damage to the competitiveness of the Hong Kong equity market.

This letter draws attention to some of the major points which are immediately apparent on reading the Report. We earnestly request Government to take these into account before it decides its next steps.

HKEx is concerned that the Report takes such a sweeping and definitive stance on a number of issues with wide-ranging and long-term implications which, to judge from the Report, have been considered only superficially. The Report appears largely to reflect a distillation of views expressed to the Group by various commentators, rather than a thorough independent analysis of the underlying facts and the merits of the different policy options available.

HKEx is especially surprised that the Group proposed a particular model (that of the United Kingdom) without (it appears from the Report) considering seriously other models which may address more effectively the root problems in the Hong Kong regulatory regime for listing matters. These comments are not intended to reflect personal criticism of the members of the Group, who no doubt worked within difficult time and resource constraints.

HKEx agrees with a number of the Group's comments on what is wrong with the present arrangements. Indeed, this is reflected in HKEx's own submissions to the Group (copies of which are enclosed). These identified the fundamental problem as Hong Kong's lack of statutory provisions applying to all listed companies, including disclosure requirements and investor remedies. HKEx put forward proposals which addressed this and other issues (including the preponderance of overseas-incorporated companies among locally-listed enterprises, which is a particular feature of Hong Kong) more comprehensively and more effectively than the recommendations in the Report. HKEx does not consider that its proposals were given a fair hearing. In fact, the core part of HKEx's proposals does not seem to have been considered at all.  We comment further on this in point 2 below.

The Report makes a number of criticisms of present arrangements, and of HKEx, which we believe reflect a failure to appreciate the real position. Most important of these (because this is the main plank in the Report's case for transferring the listing function to the SFC) is the suggestion that there is an irreconcilable conflict between HKEx's commercial and regulatory objectives. This does not correspond with reality, nor with the view taken by regulators in many other markets where exchanges have demutualised. The Report ignores the comprehensive safeguards against conflicts of interest which were put in place by Government and Legco at the demutualisation and merger of the exchanges three years ago. The Report cites no evidence that these safeguards have not worked, except to suggest that HKEx's desire to make profit has led it to approve too many listings of smaller companies which have performed badly or created regulatory problems. This suggestion is without foundation. HKEx has no commercial interest whatever in listing poor quality companies which create regulatory problems. The cost of vetting the applications of and regulating such companies far outweighs the listing fees they pay or any revenue from the turnover they generate. HKEx knows this perfectly well. HKEx also knows that its profitability depends heavily on maintaining the quality of companies it lists, because investors and issuers are attracted to a high quality market, and that is what ultimately drives HKEx's revenues.

Nor does the record support the Report's suggestion that HKEx has failed to allocate sufficient resources to enforcement as a result of a desire to make profit. Over the past three years, the total headcount for executive staff devoted to listing regulation increased from 68 to 89, while headcount of the HKEx group fell from 1065 to 791.

The Report's proposed "solution" also fails to remove the issue of conflicts because it creates new potential conflicts within the SFC, which would become both the proposer and approver of listing rules, the decision-maker on individual cases, and the sole enforcement agency (with inadequate checks and balances).  We comment further under point 5 below on how this concentration of function and power gives rise to concerns of structural bias.

HKEx agrees with the Report that market quality is a genuine issue. For this reason, we made a number of proposals in our submissions to the Group, which were designed to deal with this issue. The Report does not comment on these proposals nor does it put forward any alternative suggestions, which address the issue. The basis for its proposed solution (transferring the listing function to the SFC) seems to be an assumption that the SFC would be better at dealing with the issue than HKEx. In truth, the issue would be the same whatever party is administering the listing rules. The real issue should not be who does what, but what needs to be done. The Report does not address this.

The Report cites particularly the performance of GEM companies as evidence to support its findings. The GEM was set up (with strong encouragement from Government) to facilitate access to public capital for new and smaller companies, in line with public policy. Investors were told very clearly that this is a disclosure-based market, operating on the principle of "caveat emptor". GEM's problems have not been due to failures of disclosure. If public policy has changed regarding the objectives of this market, the answer is surely to change its standards, not the body which administers them.

The Report cites a number of statistics showing poor turnover and share price performance by many smaller companies on both the Main Board and GEM. In a bear market (which includes the deflation of a technology "bubble"), there will inevitably be many such companies. Hong Kong has fared no worse than most other international markets in this respect. Indeed, GEM has arguably performed considerably better than equivalent boards on many other exchanges. For the past two years, consistently half of all GEM-listed companies have been profitable.

A number of passages in the Report give the impression that the Group does not feel that smaller companies from the Mainland (which are often from the private sector) should be welcomed to the Hong Kong market. While HKEx is well aware of the regulatory challenges involved in admitting and regulating such companies (and the need to ensure that thorough due diligence on them has been conducted), we do not believe that seeking to deter them from listing here would be in Hong Kong's interests, or consistent with public policy. This would merely open the door for competing exchanges to erode Hong Kong's position as the primary market for Mainland companies seeking international capital.

Hong Kong has to perform a difficult regulatory balancing act, applying adequate regulation to ensure a fair and efficient market, without introducing an excessively control-oriented regime which restricts the market's development. HKEx fears that implementation of the Report's recommendations would have the effect of tilting the balance too far in the direction of control rather than growth to the overall detriment of Hong Kong. HKEx believes that a well-managed and commercially oriented stock exchange operating within a comprehensive regulatory regime and supervised by a statutory regulator is the best way to maintain this balance.

HKEx does not see how transferring responsibility for listing matters to the SFC will do anything to prevent scandals, failures in corporate disclosure or governance, and other such market problems which will inevitably arise periodically. When these occur, if HKEx is absent from the picture, there will be no "buffer" between the market and the SFC. HKEx may be happy to be relieved of this involvement, but whether this will be in the overall interests of Hong Kong is a matter which needs careful consideration.

The Report, in paragraph 2.10, takes issue with the HKEx for not using its discretion to apply qualitative factors in considering listing applications, thereby excluding potential problem companies from the market. This would imply returning to a "merit-based" regulatory system in place of the "disclosure-based" approach which is increasingly the international norm and which accords with policy enunciated by Government and the SFC. The Report concedes that the quantitative criteria for admission to the HK market are not out of line with those of other major markets. For a regulator to use qualitative (i.e. subjective) factors to reject companies which meet objective admission criteria is a dangerous path and one which is open to abuse. Among other things, it would give the impression that HKEx is providing some kind of quality assurance concerning new issues. Nor does HKEx see how transfer of the listing function to the SFC would facilitate a more "qualitative" approach. If anything, a statutory regulator is in a worse position to get into the business of "picking winners" and "weeding out bad apples" than the Listing Committee, which is composed of businessmen and market practitioners.

HKEx further believes that a statutory regulator is by its nature less well-equipped to perform the market development and marketing functions than an exchange. HKEx has played the lead role since the early 1990's in developing listing requirements and products for Mainland-based enterprises (starting with 'H' shares). As a result, Hong Kong has developed into the main international capital formation centre for China. HKEx seriously questions whether a statutory body could have done this and fears that implementation of the Group's recommendations would seriously hamper Hong Kong's efforts to remain competitive in the development and marketing of Hong Kong as a financial centre for the Mainland. We comment further on this in point 12 below. It is not correct to suggest (as paragraph 3.30 of the Report does) that HKEx has offered "regulatory concessions"  to attract listings from the Mainland. HKEx has consistently required Mainland enterprises listing in Hong Kong to comply fully with the Listing Rules and to follow Hong Kong or internationally accepted accounting standards.

Against the above background, the following are HKEx's comments on some of the major issues arising out of the Report.

• Proper Process -- HKEx is alarmed by the suggestion that Government mightendorse such radical change in a regulatory system which has been in place for over 12 years and (as observed by PIPSI) has generally worked well, without more thorough analysis of the issues or any public consultation.  The PIPSI report did not identify any deep systemic flaws or anything, which could not be put right within the existing structural framework. To by-pass public consultation (particularly on a matter of such importance) would run counter to the rule of law, to established practice and to recommendations of other reports. There is no immediate crisis which justifies the Government being stampeded into a hasty decision.
  
  While HKEx accepts that the Expert Group consulted widely in drawing up its Report, it does not follow from this that its recommendations enjoy general market and public support.  The fact that there is "overwhelming support" for change in the system does not mean that there is an overwhelming consensus in the market that the SFC should become the listing authority in place of HKEx. The public has only just seen the Report's recommendations. These are of a radical nature and many important elements in the proposed new structure have not been worked out fully (or, in some cases, at all).
  
  It is therefore (in HKEx's view) essential that proper public consultation should take place on the steps Government proposes to take in the light of the Report.
  
  

• HKEx Proposal for Core Statutory Obligations -- In its Second Submission to the Group (copy enclosed), HKEx put forward a proposal which would to a large extent have followed the North American (rather than the UK) structural model. This would involve strengthening the dual filing system by creating positive statutory reporting obligations for listed companies and their directors, including annual and half-yearly financial reporting, Management Discussion and Analysis, reporting of material changes, etc. This would mandate full and plain disclosure on an on-going basis, in relation to the secondary as well as primary markets. This should address concerns about enforcement more effectively than the Group's rather imprecise suggestions about "statutory backing"  for the Listing Rules (see further comment under point 4 below). It would also create a level playing field between HK-incorporated and overseas-incorporated HK-listed companies. It would make the SFC responsible for a uniform set of prospectus and continuous disclosure requirements and deal with the statutory vacuum which presently exists when a company de-lists or is de-listed. It would also deal with some gaps in Hong Kong 's regulatory framework relating to public unlisted companies.
  
  HKEx would, under this proposal, continue to administer the Listing Rules (as stock exchanges do in the USA and Canada). The operational interface would thus be preserved between listed companies and the operator of the market (HKEx). This is intrinsically more efficient, more market-based and more conducive to preserving the flexibility and responsiveness of the Listing Rules to changes in market practice and regulatory needs.
  
  HKEx advanced this proposal also to the Standing Committee on Company Law Reform, together with its ideas concerning additional statutory rights of action for investors (see enclosed paper submitted to the SCCLR by the HKEx Executive). HKEx believes this proposal is both a more comprehensive and a more evolutionary approach than that recommended by the Report, and is surprised that the Report makes no reference to this proposal, nor gives any indication of having considered it.
  
  There is only a passing reference in paragraphs 1.20 and 1.22 of the Report to the US listing system, which appears to be considered an inappropriate model for Hong Kong to follow on the grounds that exchanges in the US operate on a not-for-profit basis (which is not entirely correct). The description of the US and Canadian systems in Annex 3 to the Report indicates that the Group did not fully appreciate how listed company regulation in North America works. The descriptions of the US and Canadian systems make no reference to the statutory ongoing disclosure obligations found in the securities laws of the US and Canada and enforced by the statutory securities regulator. The references in the Annex to the listing rules of the NYSE and the TSX give the impression that the listing rules are the primary source of regulation of listed companies (which they presently are in Hong Kong). This is not the case. The listing rules in North America operate within a legislative framework which contains detailed statutory ongoing disclosure obligations, breaches of which are investigated and prosecuted by the statutory regulator. The listing rules in Hong Kong operate without such a statutory framework, and would continue to do so under the Group's recommendations.

• Market Quality -- HKEx agrees that this is a genuine issue and (as mentioned above) included a number of suggestions in its submissions to the Group designed to address this issue, including measures to ensure the genuineness of the public float, changes in the modus operandi of the Listing Committee, heavier responsibilities for sponsors / lead underwriters and greater segmentation of the market. The Report makes no mention of these suggestions by HKEx. More importantly, there is nothing in the Report which directly addresses the issue of market quality, beyond a recommendation that the minimum distribution requirement at IPO should be increased from 100 to 300 shareholders (which HKEx had already proposed before the Group was appointed). The Report's recommendations are based on an implied assumption that transferring the listing function to the SFC will lead to more effective vetting of listing applicants and/or a greater ability to remove under-performing companies from the market. As noted above, HKEx seriously questions this assumption.
  
  HKEx is also concerned that the Report in a number of places appears to denigrate smaller companies. The implication of paragraphs 12 and 13 is that the only relevant financial intermediaries are the global investment banks and that the only companies worthy of listing are those which a global investment bank would choose to sponsor. This approach would drive out investment banks which are not global and deny access to the market for many smaller companies. This is contrary to the purposes of a capital market and particularly of an exchange which seeks to be a primary source of equity finance for a large emerging market.

• Checks and Balances -- One of the great advantages of the present "three-tier" regulatory system for listing matters is that it provides an extra layer of checks and balances and of regulatory supervision. The exchange, as operator of the market, has "front-line" responsibility, under continuous close scrutiny by a statutory "watchdog". If the watchdog becomes the front-line regulator as well, a dimension of oversight and accountability is lost. The Report does not address this point. Indeed, by also suggesting that Government should distance itself more from regulation, and that the SFC should have the power to make rules which carry statutory backing without the need for legislative approval,the Group comes very close to recommending what amounts to a "one-tier" system.

• Structural Bias -- HKEx considers that a structure where the functions of policy maker, enforcement agency and adjudicative body are all combined in the SFC is structurally biased and will result in scepticism about the fairness of the system. This in turn will undermine the credibility of the SFC and of Hong Kong's regulatory system. The structure recommended by the Report would appear to work as follows:
  
  a.  the SFC will formulate policy and publish proposed listing rules for public consultation;
  
  b.  the SFC will make the rules;
  
  c.  the SFC will administer the rules, will use its statutory powers to investigate suspected breaches of the rules and will bring enforcement proceedings before the HKLA (i.e. SFC) against persons subject to the rules, including listed companies, directors, financial intermediaries and possibly other professional advisors;
  
  d.  the HKLA (i.e. an Executive Director of SFC) will provide persons who are alleged to have breached the rules with an opportunity to be heard and will make a decision on whether he supports HKLA staff's view that there has been a breach, including interpreting the meaning of rules promulgated by the SFC. The HKLA/ SFC will impose sanctions (with statutory backing) against the persons who it has found to have breached the rules;
  
  e.  the persons disciplined may appeal to the Listing Panel, a committee of the SFC, the members of which are appointed by the SFC.
  
  We question how the credibility of a system can be maintained where the SFC performs the functions of rule making, administering, prosecuting and adjudicating.
  
  In addition to enforcement proceedings, the SFC will also decide on the interpretation and application of the rules to a particular listed company and to a transaction. Where there is a difference of views as to the interpretation of a rule, the listed company seeking to proceed with a commercial transaction on a timely basis can either submit to the views of the SFC or file an appeal to the Listing Panel. In practice, the time required for an appeal, the costs involved and the perception of the likelihood of an SFC - appointed committee overturning an SFC decision are such that an appeal will not be considered by the market to be a practical option in most cases.

• Statutory Backing for Listing Rules !V The Report recommends that the Listing Rules should have statutory backing but not be subject to legislative vetting. HKEx believes this is both inappropriate and unlikely to work.
  
  It is inappropriate because it seeks to circumvent Legco. After years of consideration, Legco enacted the SFO. The Report proposes that the structure approved by Legco be substantively overhauled and that the SFC should be allowed to make rules, without reference to Legco, which would enable it to impose a wide range of statutory sanctions on listed companies, directors and financial intermediaries.
  
  The Group's proposal is unlikely to work. HKEx has been legally advised to the effect that because of the provisions of Section 3 of the Interpretation and General Clauses Ordinance (IGCO), which defines subsidiary legislation as "any proclamation, rule, regulation, order, resolution, notice... or other instrument made under or by virtue of any ordinance and having legislative effect", any rule made by a statutory body such as the SFC would constitute subsidiary legislation. Thus, listing rules made by the SFC should be subject to at least negative vetting by Legco.
  
  This subject is treated in Recommendation 53(e) and paragraphs 3.44-3.50 of the Report, but the Group's comments are confused. The Report refers to the SFC making subsidiary legislation under the SFO linking the Listing Rules to certain general requirements set out in law, but without turning the Rules themselves into subsidiary legislation. HKEx questions whether this is possible, given the provisions of the IGCO.
  
  Alternatively, the Report suggests that the Listing Rules should be given the status of !§codes or guidelines!��. This seems to imply that, if the SFC does not have the power to make listing rules with statutory backing in the absence of a legislative amendment, it should try to get round the problem by giving them a different name. But the fact remains that the Listing Rules are mandatory in nature. Calling mandatory rules !§codes!�� or !§guidelines!�� does not make them so.
  
  If the Group intended that the Listing Rules become true !§guidelines!��, then they would not have the force of a mandatory legal requirement. They would thus (in HKEx's view) be a less effective basis for enforcement than the present contractual relationship between each listed company and HKEx, especially if the contractual obligation were combined with the core statutory obligations for listed companies proposed by HKEx, mentioned in point 2 above.
  
  The Report claims in paragraph 2.57 that "As a statutory regulator would have a wider range of sanctions than HKEx on listed companies and company directors!K.. the enforcement of the Listing Rules under such an arrangement would have more "teeth" than the existing arrangement where HKEx administers the Rules, compliance with which by issuers are based on contractual listing agreements!K..". HKEx does not see how (consistent with fundamental rights and freedoms) the SFC could apply statutory sanctions to listed companies and their directors if there has been no breach of a statutory provision.

• Independent HKEx Subsidiary -- HKEx, in one of its submissions to the Group, put forward a proposal to create a separate subsidiary of HKEx which would perform the listing regulatory function. This is described in outline on pages 38-40 of the Report, together with the reasons why the Group rejected this proposal.
  
  Although the Group mentions having considered this proposal in detail, they did not discuss it in any detail with HKEx, nor did they respond to HKEx's offer to elaborate further on the proposal in writing or discussion. The most substantive reason is the alleged conflict of interest which, as indicated above, HKEx firmly believes is in reality a myth.
  
  HKEx believes its proposal should have received, and should still receive, more thorough consideration.
  

• Role of Market Practitioners -- The recommendations of the Group would greatly reduce the role played by "part-time volunteers" (i.e. market practitioners) in the listing decision-making process, in favour of "full-time professional regulators". The role of the present Listing Committee is reduced to hearing appeals and being a consultative body on policy issues. The Report stresses the need for full-time regulators to be capable of making decisions recognising commercial reality. But regulators will seldom or never have the commercial experience and expertise of businessmen and market practitioners. HKEx therefore doubts the wisdom of removing the practitioner input from the decision-making process on listing applications, requests for waivers, etc.
  
  It was concern about losing practitioner input which led Government in July 2002 to reverse a decision to disband the Listing Committee. The recommendations of the Group, if implemented, would constitute a reversal of last year's decision by Government to reverse its earlier decision.
  

• London Model !V HKEx does not believe that copying the London model is right for Hong Kong. The London market is very different from that of Hong Kong, which serves not only a number of international !§blue chips!�� but also the largest emerging market in the world. The overseas-incorporated companies listed in London are not analogous to those in Hong Kong. The majority of overseas companies listed in London are secondary listings and the market in these shares has a heavy professional and institutional presence. The circumstances which led to the transfer of the UKLA from the London Stock Exchange (!§LSE!��) to the FSA were very different from those of Hong Kong. We understand that conflict of interest within the LSE was not a serious concern of the UK Government, if it was a concern at all. EU requirements were a more relevant factor. The subsequent fate of the LSE, shorn of its listing function, illustrates vividly why HKEx is concerned about the Group's recommendations. For HKEx to be strategically weakened in a similar manner would not, HKEx believes, be in the interest of either its shareholders or Hong Kong.

• Investor Representatives !V The Report comments that there are no investor representatives on the HKEx Board. This overlooks the fact that, at the time of merger, six of the board members were elected by HKEx's shareholders for a term of three years and the remaining eight were appointed by Government to represent the public interest (in particular the interest of investing public), which is part of HKEx's statutory duty in any event. In fact, a number of board members are investors and are strong advocates of investor interests.

• Financial Implications -- The Report's comments on the profit / loss implications of its recommendations for HKEx, and the cost implications for issuers, appear not to have been fully thought through. Although the Group comments in general terms about its proposals being !§cost neutral!�� for issuers and !§bottom line neutral!�� for HKEx, there is no analysis of how this is to be achieved (which may be far from easy), nor does the Report address what financial arrangements are appropriate for a major publicly-listed company like HKEx which stands at the heart of Hong Kong's financial system. These points are obviously of grave concern to the HKEx board, which will need to consider these matters, taking into account the interests of its shareholders and other stakeholders.

• Market Development -- HKEx is particularly surprised by the Report's recommendation that the HKLA should be "responsible for both regulation and market development" and should "represent Hong Kong to both issuers and investors". HKEx fails to see how the statutory regulator, who does not own or operate the market, can be responsible for its development. The SFC may have a general duty to promote market development in Hong Kong, but that is not the same as actually developing listing products or trading mechanism. Only the exchange can do this.
  
  In the past three years, HKEx marketing executives have made over 250 trips to the Mainland; organized, co-organized or attended close to 100 conferences in the Mainland with over 11,300 enterprises and 19,000 persons attending, in addition to over 120 presentations made in Hong Kong. The Report cites (without supporting evidence) the increase in the number of Hong Kong listings last year (in contrast to the experience of other exchanges) as indicating that our admission criteria must be too lax. HKEx considers it reasonable to suggest that the growth in new listing is more likely due to the marketing effort made by HKEx.

• Companies Registry -- The Group proposes transferring the Companies Registry to the SFC and making the SFC the "corporate regulator!�� for all companies !V not just listed or public companies. This will have major implications for over 100,000 private companies. It may also have implications for overseas-incorporated companies which carry on business in Hong Kong. HKEx agrees that the SFC should be the statutory enforcement agency for listed companies, but this should not, in our view, involve the SFC in regulating private companies.

In the light of these points, and others which will undoubtedly arise when the Report is studied in more detail, HKEx urges Government most strongly to consider carefully the implications of implementing the Report's recommendations, particularly without public consultation. HKEx also hopes Government will examine alternative solutions which do not appear to have been considered by the Group (including HKEx's proposal outlined in point 2 above and described in more detail in the enclosures to this letter) before radical institutional change is imposed on the market with consequences which have not yet been fully assessed and will surely be very far-reaching.

Yours faithfully

For and on behalf of

Hong Kong Exchanges and Clearing Limited

Charles Lee

Chairman

Encls.

Appendix 1 !V HKEx First Submission to Expert Group

Appendix 2 !V HKEx Second Submission Expert Group

Appendix 3 !V HKEx Third Submission Expert Group

Appendix 4 - Submission to the Standing Committee on Company Law Reform by HKEx executives.

cc The Honourable Fredrick Ma - SFST